Thursday, October 20, 2016

What's Worrying the Bank of Canada?

The Bank of Canada flirted with the possibility of another interest-rate cut this month in the face of a gloomier forecast for the country’s export-led economy.

Governor Stephen Poloz and his top deputies “actively discussed” the merits of what would have been a third cut since the beginning of last year in the lead-up to Wednesday’s rate decision, he acknowledged to reporters in Ottawa.

In the end, the central bank opted to leave its benchmark rate at a still-low 0.5 per cent, because of the “significant uncertainties” clouding the bank’s economic outlook, including the tumultuous U.S. election and new mortgage insurance rules in Canada.

The central bank said it is closely monitoring the effect of the federal government’s move this month to tighten lending standards and limit access to mortgage insurance for riskier borrowers. The new rules should cool resale activity in the housing market and push developers to focus on building smaller units, the bank said.

The housing measures will slice as much as 0.3 per cent a year off economic growth by 2018 as resale activity and home construction take a hit, but they’ll also lead to “higher quality” borrowing patterns over the longer term, according to Mr. Poloz.“While household debt levels have continued to increase, these measures should, over time, help ease the growth of economic vulnerabilities related to household debt and housing,” he later told members of the Senate banking, trade and commerce committee.

Earlier Wednesday, Mr. Poloz told reporters he wants to be “dead certain” that the bank’s downgraded projection for exports is permanent. He suggested that many businesses in the all-important U.S. market may be holding off on making investments until after the election, and that affects the U.S. appetite for Canadian goods and services.

“It’s worth having a little more time to examine some of these things,” Mr. Poloz explained.

Not cutting rates was the right thing to do, Toronto-Dominion Bank economist Brian DePratto said.

“An interest rate cut would likely do little to spur exports, while potentially undoing much of the impact of recent housing market rule changes,” he argued.

The central bank now expects the economy to grow 1.1 per cent this year and 2 per cent in 2017, down from its July projection of 1.3 per cent and 2.2 per cent respectively, according to its latest monetary policy report, released Wednesday. As well, the bank said the economy won’t get back to full capacity until “around mid-2018” – at least half a year later than it predicted just three months ago.

This expected delay suggests it could be another two years before the bank starts trying to push up interest rates – a timetable that now puts it well behind the U.S. Federal Reserve and could keep a lid on the value of the Canadian dollar, now trading at about 76 cents (U.S.) for the foreseeable future.

“This is a bank that has precisely zero appetite for rate hikes, and seems to be keeping a flame alive for the possibility of rate cuts, should the need arise,” Bank of Montreal chief economist Douglas Porter said in a research note.

On the positive side, the bank said the worst may be over for the resource sector, where economic activity appears to be “bottoming out.” And the bank expects the global economy will “regain momentum” over the next two years.

Still, the bleaker forecast is the latest in a series of disappointments for Mr. Poloz, who has repeatedly predicted that a rebound in non-resource exports would lift the country out of its economic funk. The bank’s latest forecast slashes expected export growth by a full percentage-point in 2017 and 2018, shaving roughly 0.5 per cent off economic growth – and some of the loss may be permanent, rather than cyclical, according to Mr. Poloz.

“The level of exports is well below where we thought it would be by now,” Mr. Poloz told reporters. He suggested that rising protectionism, the unknown status of various free-trade deals, high electricity costs and poor infrastructure may be inhibiting investment and exports.

Wednesday’s report from the bank provides an extensive explanation for why Canada’s exports haven’t hitched themselves to the recovery in the U.S. – the destination for nearly three-quarters of Canadian goods exports. The main culprits are weaker-than-expected U.S. business investment and more pronounced competitive challenges for Canadian exporters. While a cheaper Canadian dollar has made exports more affordable to foreign buyers, the currencies of major trading rivals have declined even more against the U.S. dollar, giving them an edge in the U.S. market, the bank pointed out in its report. The Mexican peso, for example, has fallen by more than 30 per cent since mid-2014, compared with a 20-per-cent drop for the loonie.

The central bank now expects U.S. business investment to grow just 3 per cent over the next two years, down from a previous estimate of 4 per cent, due to greater uncertainty.

For the second time in seven months, Poloz whipsawed markets with prepared comments to reporters after the rate decision was released Wednesday, saying that the central bank “actively” considered adding stimulus to prop up a sluggish economy.

The Canadian dollar, which had rallied on the rates announcement at 10 a.m., erased gains after Poloz read from a separate statement 75 minutes later. Canada’s 2- and 10-year bond yields reacted in the same way, rising and then falling.

“It was interesting that he waited until the press conference to deliver the real message, which in the end was a pretty dovish one,” Alvise Marino, a foreign-exchange strategist at Credit Suisse in New York, said by phone Wednesday. “He just conveyed in a more strong way that easing is still on the table, which was something the market isn’t pricing at all.”

The moves reflect a shift under Poloz, who said in 2014 he was starting to offer more color on the bank’s deliberations in his preamble to the press conference after each quarterly release of the bank’s Monetary Policy Report. Other changes under Poloz include abandoning so-called forward guidance that gives a direct hint on the next move in borrowing costs, and adding new language to forecasts about inflation risks.

The opening statement at the press conference “fills the gap between the MPR and the press release, offering insight into which issues were really on the table during the deliberations and how those issues influenced the decision,” Bank of Canada spokeswoman Jill Vardy said in an e-mailed message. “We think this helps people understand better the thinking behind the decision and provides useful information to market participants about our risk management approach to monetary policy.”

Loonie Declines

The currency initially gained and bonds dropped after the central bank held its benchmark interest rate at 0.5 percent and the policy statement dropped a reference to downside inflation risks that featured in its previous stance from September. The markets then did an abrupt u-turn after Poloz said policy makers discussed monetary easing “in order to speed up the return of the economy to full capacity.”

The currency weakened 0.1 percent to C$1.3128 against the U.S. dollar as of 4 p.m. in Toronto, reversing a rally of as much as 0.8 percent. The rate on Canada’s bond due in November 2018 fell two basis points to 0.57 percent, after an earlier gain of two basis points (click on image).

“I was a little bit surprised how the statement and Poloz didn’t seem to line up too cleanly,” Tom Nakamura, Toronto-based vice president and portfolio manager at AGF Investments Inc. that has C$34 billion ($26 billion) under management. Some of the market reaction to the statement may have gone too far since it wasn’t out of line with Poloz’s overall worldview, he said. “What I think happens is that the market doesn’t think through the big picture sometimes.”

April Move

Investors went through a similar ride in April. Poloz held borrowing costs unchanged in the official rate decision, adding in his opening statement to reporters that the bank “entered deliberations” about easing monetary policy further. The dollar initially reversed losses after the rate announcement, only to resume declines during that press conference.

For a central bank that doesn’t offer minutes of their meetings, the context is helpful, said Marino at Credit Suisse.

“It was totally appropriate for them to say that in the press conference and not the statement,” he said. “It’s not different from what everybody else is doing.”

Investors will hear from Poloz again Wednesday, as he testifies at the Senate Banking Committee beginning at about 4:15 p.m. Another opening statement is expected.

You can view the Bank of Canada's latest Monetary Policy Report here and I embedded the press conference below (it is also available here).

Let me give you my quick thoughts on the latest decision, the press conference, the loonie and other currencies:

There was no surprise that the Bank of Canada decided to leave rates unchanged since oil prices have been hovering near $50 a barrel, bolstering the loonie and tightening financial conditions (remember, the loonie is a petro currency, as oil rises, it follows, lifting the pressure on the BoC to raise rates as financial conditions tighten).

The big surprise came after during the press release when Steve Poloz said he and his top deputies "actively discussed" the merits of another rate cut. Why were they actively discussing this? No doubt, the Bank is worried about weakness in real estate and exports but I also think there was an active discussion on whether global deflation risks are really fading and more importantly, whether Janet Yellen's speech last Friday was a real game changer.

By all accounts, the Fed is set to raise rates by 25 basis points in December but during her speech last Friday, Fed ChairYellen dropped a bomb stating the Fed might need to stay accommodative for longer and risk overshooting its 2% inflation target.

I interpreted these remarks as the Fed is still worried about global deflation and might even fear it's behind the deflation curve, so there is no rush to raise rates and it might be smarter to stay accommodative for longer, even if that means risking inflation down the road (they won't publicly admit this but they'd much prefer inflation than deflation even if it will take a miracle to achieve this outcome by inflating risks assets which only exacerbates rising inequality and the retirement crisis which ironically exacerbates deflation!!).

What signal is the Fed sending to the Bank of Canada and other central banks? Basically, have no fear, the Fed is in no hurry to raise rates and even if it does raise in December, it will be a one and done deal.

I spoke to my buddy in Toronto this morning. He runs a one-man currency hedge fund machine and he was telling me that he thinks now is the the time to take profits on the long USD position and if the DXY goes over 99, start shorting the greenback. He also told me to he's long the British pound (especially versus the euro) but thinks the Canadian dollar could fall as low as 73 cents (oil prices between $50 and $60 will help Alberta and bolster the loonie but slowdown in real estate and exports and divergence in monetary policy will weigh on the Canadian currency).

Obviously my buddy who has been trading currencies for over 25 years knows what he's doing and I agree with him on a cyclical basis, especially after Yellen's speech, but structurally, I remain short currencies in regions where deflation is wreaking havoc on the economy and if a financial crisis erupts anywhere, King Dollar will surge much higher.

My buddy also told me that the pickup in China's PPI last week was all due to the devaluation in the Chinese currency, allowing them to import inflation but he too doesn't see this as a sustainable strategy.

That brings me back to the Bank of Canada's decision and press conference. Steve Poloz was the head of Export Development Canada prior to being nominated Governor of the Bank of Canada. I worked with him in the late nineties at BCA Research when he was a Managing Editor covering G7 economies. He's extremely smart, knows his stuff and is very nice. I have nothing but praise for him even if he pisses off market participants at times (who cares, maybe they aren't reading him right or listening carefully to his message).

I trust Steve's judgment but I also worry that Canadian exports will lag in an environment where US protectionism is on the rise (regardless if Trump loses) and other countries like Mexico keep devaluing their currency to gain US market share.

In other words, if oil keeps rising or hovering above $50 but Canadian exports don't pick up, or worse still, the housing market craters, don't be surprised if the Bank of Canada cuts rates or even starts engaging in QE. We are far from there but I'm very worried that Canada's days are numbered and have been short the loonie since December 2013 (and remain short).

Speaking of BCA Research, I see Gerard MacDonell is back from vacation and posting all sorts of comments on his blog. I ignore his political rants/ jibberish but love reading his market insights like his latest on the core PCE deflator looking firm in September. I will let you read it.

Below, the press conference where Bank of Canada Governor Stephen S. Poloz and Senior Deputy Governor Carolyn Wilkins discuss the October Monetary Policy Report. I also embedded the press conference where ECB President Mario Draghi explains the decision to keep rates on hold and once again reaffirmed plans to maintain the quantitative easing program at €80 billion to March 2017 or beyond if needed. The ECB left the door open to more stimulus, pointing to the December meeting.

Part of me misses those Friday afternoon sessions at BCA Research back in the day when Steve Poloz and other smart Managing Editors like Gerard, Francis Scotland, Chen Zhao, Warren Smith, Martin Barnes and Dave Abramson would all get into it and "actively discuss" their market views (sometimes it was warfare!).

I got to hand it to Tony Boeckh, he knew how to recruit them and pit them against each other, which made for a lousy work environment but great for his bottom line. Tony's business model was simple, recruit a few top guns from industry and the government, hire a bunch of hungry and smart university students and pay them in Canadian dollars, and deliver great investment research which is sold to clients all over the world charging them US dollars (pure genius which is why he made a fortune when he sold BCA several years ago to manage his money and write his investment letter).

Unfortunately, I don't have Tony Boeckh's business savvy so I will remind all of you to kindly subscribe and/ or donate to this blog on the top right-hand side under my picture. I thank those of you who support my efforts, I truly appreciate it.

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